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Value Investment Opportunity or Irrational Exuberance?

- By Logan Burgess

It's hard to open a Web browser this week without seeing Starbucks (SBUX). Following a report by the analysis firm Nomura (NMR), the Web has been flooded with stories projecting Starbucks will soon overtake McDonald's (MCD) as the world's most valuable restaurant chain. Is Starbucks a buy for value investors - or showing signs of irrational exuberance?


The market certainly has exuberance.

The chart below shows Google searches for "Starbucks" in the U.S. since 2004. Google indexes this search data, meaning that the highest volume of search traffic during the time period equals 100. A value of 50 means the search term was half as popular. This week has seen the most Google searches for "Starbucks" since 2004 when Google began tracking this traffic.

Holding all things equal (like consumers looking for a store location), it is safe to assume this week's Web traffic is the result of investment interest. Anecdotal evidence of market exuberance can be found here, here and here.

One of the most simple yet legendary quotes from Warren Buffett should give any value investor pause:


"Be fearful when others are greedy and greedy when others are fearful." - Warren Buffett



From the headlines, Starbucks should be a buy for value investors. Here are two reasons to remain cautiously optimistic when looking at the company.

The current stock price

As value investors, we seek out favor stocks that are ripe for potential. Starbucks had a truly atrocious year in 2016. In a market that returned roughly 12%, Starbucks was down 7.51%. The company's main competitors, McDonald's and Dunkin' Donuts (DNKN), returned 3.03% and 23.13%.

News stories that focus on Starbucks' performance in 2016 miss the larger picture. Over the last decade, Starbucks significantly outperformed the general stock market and ran toe to toe with McDonald's. Both stocks are trading up nearly 250% since January 2007 while Dunkin' Donuts was the laggard, trading up 109% since going public in 2011.

2016 was a hard year, but Starbucks has been a true golden child of the U.S. stock market run since 2008 and has seen considerable price appreciation.

Even more important than the charts is the fact that Starbucks remains relatively expensive when compared to the competition. Yes, a higher forward price-earnings (P/E) does capture investor expectations for future growth. However, for a value investor, it is a risky proposition to bet on this forward growth when current valuations are high. Undervalued and out-of-favor stocks are the preferable course.

Company

P/E (TTM)

Forward P/E

Starbucks

29.46

25.91

Dunkin' Donuts

36.85

21.60

McDonald's

22.58

19.31

S&P 500

25.98



A strengthening dollar and global uncertainty

A major component of the Nomura report was expectations for ambitious international expansion by Starbucks in the future. With nearly 25,000 stores in 2016, the firm has set a goal of reaching 37,000 stores by 2021. In Nomura's report, the analytical firm projects that 50,000 worldwide stores could be in the cards for the company longer term.

In 2017 and beyond, geopolitical issues could slow this projected growth in store locations. As Donald Trump prepares to take office in two weeks, we are likely entering a new era of foreign policy - one that will strain existing foreign relations and bring about a protectionist world view. How will trade partners react to U.S. firms expanding operations within their borders?

Even if these stores are opened, we need to consider the profitability of these new locations. As these locations receive revenue in local currency and convert profit into U.S. dollars, foreign exchange risk is ever present. A stronger U.S. dollar means that these local profits have less "punch" when they make it to quarterly earnings reports. The dollar index has been up significantly since the U.S. election, and expectations are for this trend to continue into 2017.

Disclosure: I hold no positions referenced in this article.

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This article first appeared on GuruFocus.